Monday, 27 May 2013

In its conflict with the central bank, the Iraqi
government got its economics wrong. Twice.

The last few weeks saw a
further decline in the value of the Iraqi dinar. The
gap between market and the official exchange rates reached its peak in the
second week of May when the dollar was being sold for around 1290 dinars; 10%
above the official rate of 1166 dinars to the dollar. This might be surprising
since for several years prior to 2012, the Central Bank of Iraq (CBI) managed
to maintain a narrow gap between the official and market rates using
its daily currency auctions.

The story of how the Iraqi
foreign exchange market went from stability to volatility in the space of 18
months can be divided into three episodes.

Episode 1 (Jan 2012 – May 2012): Two explanations for
an emerging gap

In early 2012, The CBI and
the government offered two different explanations for a newly-emerging gap emerged
between official and market exchange rates. Mudher Salih, then the deputy governor
of the CBI, attributed the gap to excess demand from the neighbouring Syria and
Iran—which were facing foreign currency shortages due to sanctions. Meanwhile, Izzat Al-Shahbandar, an MP and an aide to PM
Maliki, blamed the stringent measures of the CBI, which hindered the foreign currency
supply, for the emergence of the gap. Shahbandar claimed that prior to 2012, the CBI sold $200 million on average in its daily auctions, but that figure fell to
$100 million in 2012.

Contrary to Shahbandar’s
claims however, CBI’s data (summarised in the table below) show that the amount
of dollars sold had in fact increased in
the period from January to May 2012 relative to previous years. The data leaves
little doubt which of the two explanations is more plausible - the only question mark is about the source of Shahbandar's figures.

To meet the excess demand,
the CBI significantly increased its supply of dollars, successfully bringing
the market price down to within 3% of the official rate in early October (see the
chart below). At that point, an arrest warrant was issued against its governor,
Sinan Al-Shabibi, over allegations of “of financial irregularities” related to the currency
auctions. A more detailed report by the Board of Supreme Audit (BSA) concluded
that the CBI’s loose control over the auctions encouraged smuggling of the
dollar out of the country and money laundering.

The change in tone is
notable: in October, the CBI was being accused of leniency in running its
currency auctions, having been (falsely) accused of stringency in May!

Episode 3 (Oct 2012 – present): The CBI restricts
dollar supply

Over this period, volumes
in the CBI’s auctions averaged $177 million—a significant drop from the
previous episode. This appears to be a deliberate policy as can be inferred
from the appointment of the head of the BSA as the interim governor and CBI’s
statements on 18 and 24 October 2012.

An unsurprising outcome of
restricted supply is the significant rise in the market value of the dollar,
which reached a high this month. It is hard to tell what is going to happen
next, but the politicians who have been
actively involved in the saga now seem concerned with the uncomfortable fall of the
dinar.

Epilogue

The last part of the chart
shows a sharp pick-up in the auction volumes over the last few days (almost to the
levels reached by Shabibi before his dismissal) coupled with a narrowing of the
gap between market and official rates. It would be a positive change if this
trend continued. Currency smuggling, unnecessary depletion of CBI’s resources
and money laundering must be fought of course. But this should be done through
a legal and supervisory framework not through the excessively powerful tools of
monetary policy. One should not starve the patient to death in order to kill
the bacteria.

Monday, 20 May 2013

Iraq was fortunate to avoid an external financing crisis,
but failed to deliver on structural reforms.

Arab countries that are seeking
help from the International Monetary Fund (IMF) fall into one of two
categories: countries which have experienced recent political change such as
Yemen, Tunisia and Egypt; and oil-importing ones exposed to high price shocks. It
may then seem surprising that Iraq—an oil-exporter with an unchanged prime
minister since 2006—has been until recently engaged in a programme with the IMF.

A little historical background
may help explain this. Oil prices experienced a large drop in 2009 following
the global financial crisis and the economic recession that ensued. The price
of an Iraqi barrel of oil fell from $124 in mid-2008 to $35 in early 2009
before picking up later in the year. For an economy where oil accounts for 95%
of total exports and 90% of the government’s revenue, this risked creating a
hole in the financing of both the government’s budget and imports.

The second column of the
table illustrates this by showing the calculations carried out in February 2010
when Iraq applied for help. Assuming an average oil price of $62.5 per barrel
and average exporting volume of 2.1 million barrels per day, Iraq would have
had a $5 billion gap in financing its transactions with the outside world
through 2011. Faced with this risk, Iraqi officials agreed with the IMF on a
two-year programme and a $3.7 billion loan was approved on 24 February
2010.

As it turned out, the risks
did not materialise and oil prices recovered from their 2009 lows. My calculations—shown
in the third column of the table—suggest that the financing gap was reduced to
$3 billion by the end of 2010 as Iraqi oil price averaged $74 per barrel in
2010, more than compensating for the failure to meet the export volume target. By
the time the programme had its second assessment in March 2011, the financing
gap was all but eliminated under the government’s new conservative assumptions for oil price ($76.5) and export volume (2.2 million barrels per
day) as shown in the last column of the table.

At the stage, the
programme’s main focus shifted from “covering the balance of payments needs” to
providing “a framework for advancing structural reforms”. This included
improving accounting, auditing and reporting practices; restructuring and
recapitalising the two main state-owned banks; and improving public financial
management. However, the programme became a frustrating affair from this point on. Progress
slowed down, reviews were delayed and eventually never carried out, and the
programme deadline was extended twice, first to July 2012 and then to February
2013, when it finally expired.

In summary, the programme was
one of two halves. The first focused on avoiding a balance-of-payments crisis,
which Iraq managed to do more by luck than judgement. But higher oil prices,
which were the main reason for preventing the crisis, weakened the appetite for
change. It is fair to say that the second half of the programme, designed to
advance structural reforms, was a complete and utter failure.

Sunday, 12 May 2013

Egypt is going through the third
phase of its economic crisis. It will not be the last one.

A cabinet reshuffle was
announced last week in Egypt. Nine
ministers were replaced including the incumbents of the three economic posts
in the ministries of Finance, Planning and International Cooperation, and
Investment. The new government faces considerable economic challenges, arguably
the most urgent of which is related to Egypt’s balance of payments with the
outside world.

The problem stems from the
conflict between Egypt’s desire to prevent the value of its pound from falling
and direction of fundamental economic forces. Even before the 2011 Revolution,
Egypt was experiencing a deficit in its current account—which includes net
purchases of goods and services as well as remittances from Egyptians abroad.
The crisis has unfolded in three phases determined by how the current account
deficit was financed.

Phase 1: Current account deficit financed by foreign
investments. Foreign investments include direct ones such as buying factories and
infrastructure projects and also financial investments into the Egyptian stock
market or government bonds. As the chart shows, direct and portfolio
investments were more than sufficient to cover the current account deficit in
the years just before the Revolution. As a result, reserves at the Central Bank
of Egypt (CBE) reached a peak of $36 billion at the end of 2010, a date that
marks the end of this phase.

Phase 2: Larger current account deficit and financial
account deficit financed by CBE’s reserves. Three things changed after the Revolution.
First, despite the rise in remittances, the current account deficit grew larger mainly due to the fall in tourism. Second, direct investments halted to
near zero. Third, foreign capital flows into the Egyptian stock and bond
markets quickly reversed course and flowed out of the country (the light blue
bar in the chart).

The changes put downward
pressure on the pound but the currency was supported by the CBE’s intervention in
the foreign exchange market using its international reserves. This phase continued
until reserves fell below the minimum safety level—estimated by the CBE to be
around $15 billion—in the second half of 2012.

Phase 3: Current account deficit financed by loans
from other countries. With international reserves all but exhausted, the government—loathed to
accept a currency depreciation—started to look for alternative sources of
external funding. It was during this phase that it reached a preliminary
agreement with the IMF in November 2012 only to backtrack on the deal. Instead,
the government managed to finance the current account deficit with loans from
Turkey, Saudi Arabia, Libya and especially Qatar. Most of these loans are in
the form of deposits at the CBE, some of which can already be seen as the dark-grey
bar in the chart and more are likely to show up when the CBE publishes the
balance of payments figures for the latest quarter. Indeed, thanks to these
loans the CBE
announced last Wednesday that its foreign currency reserves had increased by $1
billion in April.

The current phase is both
unsustainable and undesirable, and a correction is needed. The IMF may or may
not be involved in the correction process (although it is likely
that it would), but chances are there will be a fourth phase in Egypt’s
economic tale.

Sunday, 5 May 2013

The Egyptian president,
Mohamed Morsi, has already answered the question in the title by declaring that “Egypt
will never go bankrupt”. But judging by some of the recent headlines, sceptics are still
unconvinced. What does it mean for a country to go bankrupt anyway? And is
Egypt really on the brink of financial collapse?

Rather than using the
poorly-defined term “bankruptcy”, an alternative way for analysing the
financial sustainability of a country is to assess its ability to meet its
external financing needs, which consist of:

·Trade deficit (excess
imports over exports)

·Interest payment on
existing debt

·Paying back external debts
as they fall due

In the short term, external
financing needs can be met by borrowing or drawing from foreign currency
reserves. But no country can borrow forever and reserves will eventually be
exhausted, so the economy must eventually adjust to rebalance external finances.

In an ideal world, the
adjustment is done in a benign manner in which the country gradually winds down
its debt, boosts exports and reduces imports costs. But in times of crisis, a
country may be forced to do the whole adjustment momentarily by defaulting on
debt and instantaneously cutting imports—including food, medicines and energy
needs. This is the dreaded “going bankrupt” scenario. One reason for the
unpopularity of the IMF standard conditions is that the speed of adjustment they
require is too quick for most countries’ liking.

So what are the external
financing needs for Egypt over the next few months? And does it have sufficient
funds to avoid hard-landing?

The IMF currently estimates Egypt’s external financing
needs to be $11.7 billion. This figure can be split into $5 billion of expected
current account deficit (that is trade deficit plus interest payment), and $6.7
billion of maturing external debt over the next 12 months. Raising $11.7 billion
over 12 months may seem formidable, especially without the help of the central
bank’s foreign currency reserves which are near their minimum safety level. But
a more careful look at the numbers suggests it is not so bad.

According to the Central
Bank of Egypt (CBE), of the $6.7 billion of external debt maturing this year, $4
billion are Qatari deposits which are unlikely to be paid back anytime soon. On
top of that, Egypt has recently managed to borrow $2 billion from Libya and an additional $3 billion from Qatar. With a further $1 billion
transfer from Turkey and a potential loan from Russia, the Egyptian government seems
to have secured most of its external financing needs for the next few months as
the table below shows.

Despite its success in
securing loans, the government’s strategy carries some risks. First, it could
unravel if the financing needs increased unexpectedly as a result of energy or
food price shock. A second risk is that of a speculative attack
on the Egyptian pound, especially with the CBE unwilling and unable to fend them off. Third, the over-reliance on Qatari funds to keep the Egyptian
economy on its feet may raise questions about the political price being paid.
Fourth, even if this tactic proves successful, it is at best a short-term fix
rather than a long-term solution.

But the Egyptian government
seems willing to take these risks rather than embarking on the unpopular and
painful economic measures requested by the IMF. Perhaps it is hoping to kick
the can just far enough down the road beyond parliamentary elections.

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About Me (Ziad Daoud)

I am an economist currently based in the Middle East. I have previously worked for an asset management firm and, before that, I did a PhD at the London School of Economics. The views in this blog are solely my own.